The Incentive and Signaling Effects of Annual Bonus Schemes: Evidence from Firm Innovation

Abstract

This study investigates whether firm innovation can be systematically traced to the CEO's performance evaluation made by boards of directors. In evaluating CEO performance, the board can (i) assess and evaluate performance on job aspects that are per-se difficult to measure and (ii) signal firm value to outsiders without having to disclose competitively sensitive details. In this paper, I argue that these features of CEO performance evaluation are central to understanding how boards motivate innovation. The first feature increases the effort allocation towards innovation, while the second feature increases the incentive intensity of equity incentives. As a result, I expect that firm innovation is positively related to the presence of board's private measures in evaluating the CEO, and more importantly, positively related to the interaction of private measures and equity incentives. Empirical results are in line with both expectations. Overall, findings suggest that boards can reduce incentive problems associated with equity ownership in high information asymmetry environments by signaling innovation without disclosing competitively sensitive details.